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You are hired as the credit risk manager for a large bank. You find that the bank’s credits are poorly diversified. The bank has an extremely large exposure to one firm with a BB rating. All its other loans have the equivalent of an AAA rating. You recommend that the bank diversify its credit exposures. After the bank follows your advice, you are summoned to the CEO’s office and fired. The CEO says that they followed your advice, acquired many small exposures to firms with BB ratings to replace the large exposure, and all it did was to make the bank riskier because its credit VaR increased. The bank measures its credit VaR as the maximum loss of principal over one year at the 1% level. You seek advice from a consultant to make sure not to repeat the mistake you made. Which of the following explanations provided by the consultant is correct?
Choose one answer.